When Oracle Corp. was in its formative stage, CEO Larry Ellison was pitching one very large customer-the CIA. Soon thereafter Oracle was building databases for the security agency, and today, 25 years later, 23% of Oracle’s total revenue comes from government-related contracts.
Internet gear-maker Cisco Systems pursued a similar strategy in 1986 and began pitching its products to Uncle Sam. Now, according to Cisco CEO John Chambers, the company derives at least 10% to 15% of its U.S. enterprise sales from the federal government.
Both examples offer clear lessons for entrepreneurs and VCs as they search for new and ever more elusive sources of information technology spending. Now, more than ever, government may be their salvation.
Where’s The Growth?
In its December survey of IT budgets for 100 of the largest 1,000 U.S. companies, investment firm Goldman Sachs did not have very good news for the technology industry. Goldman found that the outlook for corporate IT spending in 2003 is likely to decline 1%, compared with estimates of 2% to 3% growth in a previous survey. These rates are far below the 10% to 12% annual growth rates seen during much of the 1990s and indicate that demand must be found outside of commercial enterprise if there is any hope to expand technology sales.
Enter the federal government. As the Department of Homeland Security takes shape-squeezing 22 agencies and up to 170,000 government employees under one roof-and previously budgeted technology upgrades across the military and civilian agencies come online, government spending will pick up where corporate spending has slacked off.
Even before Sept. 11, federal, state and local government spending on IT totaled as much as $150 billion annually, or 20% of entire IT industry sales, according to the Information Technology Association of America, a technology trade group based in Arlington, Va. The Government Electronics and Information Technology Association (GEIA) further estimates federal IT spending will increase 9.7% in fiscal 2003 to $53.1 billion, split almost evenly between the Defense Department and civilian agencies. GEIA also predicts that the military’s $26.6 billion IT budget for fiscal 2003 will rise to $34 billion by fiscal 2008 and that this year’s $26.5 billion civilian IT budget will rise to $33.1 billion by 2008.
Says Tom Gann, head of enterprise software company Siebel Systems’ public sector group: “That $53 billion will only continue to expand as technology continues to tackle cross-agency [government] projects.” All of which makes obtaining government business a holy grail for venture backed firms and their larger more established high-tech brethren.
Mind you, selling to government is easier said than done. Extra long sales cycles, government approved accounting systems and myriad bureaucracies can frustrate even the likes of Cisco and Oracle, let alone venture-backed startups. Those who’ve been through the process offer tips for the uninitiated.
First, just as with the commercial enterprise, “know your customer and understand your customer’s needs,” says Alex Hern, general partner and founder of Silicon Valley Innovation Capital (SVIC), a Palo Alto, Calif.-based venture firm specializing in high-tech security and government-related startups. “The federal government has always been a great customer of IT but it’s been underserved by venture-backed companies.”
Second, instead of selling directly to the federal government, startups must try to sell to the large technology integrators that often win the huge government contracts. This is especially true for venture-backed private companies with modest track records and a reputation for instability. “If you’re selling paper clips to the government, it’s easier to sell it one box than it is to sell it a million boxes,” says Ross Smith, executive vice-president and co-founder of Quantum 3D, a chipmaker for visual simulators that sells to both the military and commercial enterprises. “When you want the big bucks you need to find a Lockheed Martin or a Northrop or an EDS and become their darling,” Smith says. “For venture-backed companies, that’s the way to do it.”
Larger first-tier government systems integrators know how to navigate through government budgets and bureaucracies. They have well-established relationships with government agencies, but they often work with smaller technology companies because they need the smaller companies’ specialized products and services to fill portions of large multibillion dollar government contracts. In this way, even a small, venture-backed company like Quantum 3D has fulfilled the visual simulation needs for various parts of the military. Says Smith: “Whereas government is still concerned with the stability of venture-backed companies, the integrators are more comfortable dealing with them. However, integrators often look for assurances against instability just in case you do go out of business, and they’ll build it into the contracts. … They’ll escrow your software code or the hardware design, so you have to be careful.”
Homeland Security Myth?
No one wants to say it out loud, but the homeland security initiative is viewed with eager eyes by the tech industry, even though few are sure when the large IT dollars will actually kick in.
Beyond the federal government’s roughly $53 billion budget for IT in 2003, another $37.7 billion has been slated to help establish, integrate and streamline homeland security over the next several years. In the short term, congress has authorized $500 million to pay for new technologies in this, the first year of the department’s operation. Technology executives like Smith warn that the figure will be closer to $100 million for 2003.
Nevertheless, so much money is to be thrown at this one area of government that some of the largest companies in tech have formed their own homeland security departments charged with meeting the needs of the agency and ultimately generating huge revenue from its creation. “The last time something of this magnitude was done was 40 years ago when the Department of Defense was formed,” says Siebel’s Gann.
While players like Siebel might eye CRM sales across several agencies and Cisco might wish to upgrade all of the networking equipment within the National Security Agency, small security startups have the opportunity to take advantage of homeland security spending as well. “Often the spook and special forces business is a good space for niche technologies, because these areas have more discretionary income and you don’t have to deal with the same elongated product cycles of typical government contracts,” says Smith.
That’s what SVIC is counting on and why it has backed certain startups, like ArcSight, a sort of air traffic control system for security applications used in both the government and commercial enterprise. In-Q-Tel, the CIA’s venture arm, is among the company’s investors. As SVIC’s Hern sees it, the way the firm helped build ArcSight is the way all venture-backed startups intent on selling to the government should be built. “The government has specific needs and it has a technology roadmap,” he says. “VCs should simply go out and talk to the federal government. Believe it or not, it’s not rocket science.”
(For more on the subject of tapping into defense electronics spending, see The Carlyle Group’s outlook).
Peter Henig is a freelance writer who specializes in writing about venture capital and startups.